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Bar News - March 18, 2015

Elder, Estate Planning & Probate Law: Planning for Transition: Passing on the Family Business


The list of issues that successful small business owners worry about these days is endless – from staffing and payroll to capital needs and expansion. In many cases, the owners turn to one or more of their children to become involved in the day-to-day operations of the business. Those children become instrumental in running the business and often can become the strategic vision for the future. And then it is suddenly time to think about passing ownership and equity down to them.

There are myriad issues to consider in passing a business on to children. Often the first consideration is whether the transition will happen during the life of the business owner or at death. The second “global” issue is “gift versus sale.” Specifically, the transfer can be structured as a gift or bequest, a sale for fair market value, a sale for less than fair market value, or a small transfer or issuance of business interests to the child or children followed by a redemption of the remaining business interests by the company.

A transfer during life allows the owner to control and oversee the process, ensuring a smooth transition of important relationships with third parties. If the transfer is to occur only upon death, it can be structured as an inheritance or a sale by the owner’s estate or revocable trust. However, without a written plan for the transfer, whether within estate planning documents or within certain governing documents, such as an LLC’s operating agreement, a partnership agreement, or a shareholders’ agreement, the structure may be determined by the children or by the legal representative of the deceased owner (executor or trustee).

A lifetime transfer, whether by gift or sale, may result in the owner relinquishing control of the business, which many owners are not prepared to do. Although a partial transfer during life can serve the important purpose of vesting some equity ownership in the children who are active in the business, it still requires a plan for the completion of the transfer to occur at death and possibly another equalization plan to be in place for the other children.

A sale during the owner’s life allows the owner to receive money that can be used for retirement. Also, unlike a gift of the business, a sale maintains parity between the child or children who will own the business and those who will not. However, a sale during the owner’s life will likely have significant income tax consequences to the owner, who may have little or no basis in his or her stock or other ownership interest. Tax consequences can be mitigated if the sale is structured as an installment sale, but then the owner is dependent on the ongoing success of the business at a level sufficient to generate the funds necessary to pay future installments.

On the other hand, a sale at death minimizes the income tax consequences, because the stock or other ownership interest will receive a step-up in basis upon the owner’s death. However, waiting until death often means that the owner will need to stay active in the business or pull equity out of the business in some fashion to generate cash flow for the owner’s continuing support, and then hope for the children to remain committed and engaged, despite not gaining any ownership until the parent’s death.

A gift during the life of the owner eliminates income tax consequences for the owner and alleviates the need for the child to be able to finance a purchase, but does not create an income stream for the owner, unless the gift can be accomplished using a “grantor retained annuity trust,” or “GRAT.” In addition, if one or more children are not receiving a share of the business, then the owner may be faced with treating other children differently, particularly if he or she is not in a position to gift other assets to those children at the same time.

Equalization can occur at death if there are sufficient other assets. If there are not sufficient other assets, then purchasing life insurance to “fund” equalization can be a solution, if the owner can afford to do so. Typically the insurance will be purchased by an irrevocable life insurance trust so that the proceeds are not includible in the owner’s gross estate for estate tax purposes. However, equalization provisions in the owner’s estate planning documents can be complicated and often do not achieve precise equality among the children, resulting in hurt feelings or possibly challenges to the overall plan.

In many cases, the business is the parent’s largest asset and less than all the children are active in the business. In addition, often the business is the owner’s primary source of income. If the active children cannot afford to purchase some or all of the business to create a pool of assets for the parent to use during retirement and to leave in an equitable manner to the other children, the only option may be to transfer the business to all the children, including those who are not active in the business.

There are mechanisms to accommodate these circumstances. One method is to recapitalize the business into voting and non-voting interests and then transfer the voting interests to the active children and the non-voting interests to the children not active in the business.

Another approach is to transfer the operating business to the active children and the business real estate (which is often held in a separate entity) to the other children, so that all the children receive equivalent value. The latter option also gives all the children an income stream, some from the business itself and others from the rent paid on the business real estate.

What is clear is that successful intra-family business succession requires planning well in advance of the transfer itself. Tax consequences, cash-flow planning for the parent, and estate planning for children not active in the business are all issues that need to be considered and addressed. Moreover, the parent needs to set the expectations for all the children and to demonstrate that a fair and equitable plan has been developed to ensure the future success of the business and of the family.

Anu R. Mullikin

Michelle M. Arruda

Anu R. Mullikin is a shareholder of Devine Millimet and chairs the trust and estates practice group. She can be reached at (603) 695-8536, or by email.

Michelle M. Arruda is a shareholder and a member of the firm’s trusts and estates practice group. She can be reached at (603) 410-1705, or by email.

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